March 22, 2015

Hottest Oil & Gas Claims, Part 1: Busting Leases

The collapse in oil prices since June 2014, and the significant drop in those for natural gas, have put tremendous pressures on relationships in the industry. The stresses -- between operators and non-operators, lessees and royalty owners, principals and contractors, investors and investees, among others -- make legal disputes both more likely and harder to forgive.

In light of the strains within the oil and gas industry, what sorts of claims can you expect to see in 2015? In this series -- which originated as a paper for the 66th Annual Oil & Gas Law Conference in Houston -- Blawgletter will offer the top seven answers.

We start with Busting leases – when does failing to produce in paying quantities entitle the lessor to kick the lessee out?

Why bust a lease

Let's start with the why -- what could prompt a party to a lease to want to bring it to an end. The answer generally has to do with the terms of the lease or with the parties' course of performance under it. The minerals owner -- the lessor -- will prefer a higher royalty rate (25 percent, say) over a lower one (12.5 percent, for instance) because the higher percentage means more money to her. The lessee, on the other hand, will want to pay as a smaller percentage. And all kinds of difficulties and breaches may make either party unhappy with the contractual relationship and therefore anxious to end it.

Legal backdrop

The ability of a well to produce oil or gas “in paying quantities” generally will extend the lease until the quantities will no longer pay a profit, even a “small” one. Clifton v. Koontz, 160 Tex. 82, 325 S.W.2d 684, 690-91 (1959). “Whether there is a reasonable basis for the expectation of profitable returns from the well is the test.” Id. at 691; see, e.g., T.W. Phillips Gas & Oil Co. v. Jedlicka, 615 Pa. 199, 42 A.3d 261, 276 (2012) (applying Cliftonstandard). Several factors may enter into the analysis, including what constitutes “a reasonable period of time under the circumstances” for turning a profit. Clifton, 325 S.W.2d at 691.

The capacity to produce at a profit holds the lease whether or not profitable production in fact occurs, but the well must flow without additional equipment or repair. See, e.g., Anadarko Petroleum Corp. v. Thompson,94 S.W.3d 550, 557-58 (Tex. 2002); Pack v. Santa Fe Minerals, 869 P.2d 323, 326-27 (Okla. 1994) (stating that “the lease in the case at bar cannot terminate under the terms of the habendum clause because the parties stipulated that the subject wells were at all times capable of producing in paying quantities”). Even if a well no longer pays but still produces some oil or gas, a second prong of the test may save the lease anyway. In that situation, the party seeking to end a lease must show also that a reasonably prudent operator would not have continued operations for the purpose of profit rather than mere speculation. EnerQuest Oil & Gas, LLC v. Plains Expl. & Prod. Co., 981 F. Supp. 2d 575, 597 (W.D. Tex. 2013) (citingCannon v. Sun-Key Oil Co., Inc., 117 S.W.3d 416,421 (Tex. App. – Eastland 2003, pet. denied)). A total cessation of production may also permit termination of a lease. Cannon, 117 S.W.3d at 421-22.

Changes in market prices of course affect whether or not a well can produce in paying quantities. A large price rise may make low-producing wells capable of paying, while a plunge in price may turn profitable wells into losers. In the pricing climate of early 2015 – when crude oil prices in the U.S. had fallen from more than $100 per barrel (in June 2014) to less than $45 and gas had gone from over $4 per MMBtu (with a $6 spike in February 2014) to below $3 – some lessors and lessees who want to break leases may have a chance.

Claim economics

The basic economics of pursuing claims (whether in a lawsuit, arbitration, or otherwise) will make some claims more viable than others. In general, the same traits that render a claim attractive to a contingent-fee lawyer will determine whether the potential gain supports risking your own resources (e.g., hourly fees plus expenses) in the endeavor. On a lease-busting claim by a lessee for failure to produce in paying quantities, favorable characteristics will include these:

Large non-producing reserves within the lease area (making the future bright for whoever controls the minerals);

Successful use of production-maximizing techniques in the relevant formation on or near the acreage (tending to enhance the revenue stream);

Demand for but failure of the operator to employ the successful techniques or perform repairs, including as a result of financial distress (putting the equities on the lessor's side);

Pipeline access from the tract to points of sale (improving the ability to obtain market prices); and

Low wellhead prices due to temporary oversupply (possibly implying a speculative motive on the part of the operator for holding the lease).

These features suggest a situation in which an operator may have sacrificed the lessee’s interest in maximizing current production (and therefore royalties) at the altar of saving money during an industry downturn. They also indicate a potentially large upside for the mineral owner, who without the existing lease could enter into a more favorable one or develop the minerals herself.

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Next in the series -- the obligation of operators to use the latest technology for drilling and completing wells.